Income Tax Treatment for Royalty and Fee for Technical Services (FTS)

Content

1. What is meaning of Person?
2. Source and Residence Rules
3. Meaning and Scope of Total Income - Section - 2(24) and 5
4. Income deemed to accrue or arise in India? - Section - 9
5. Meaning and Scope of Royalty Income
6. Meaning and Scope of Fee for Technical Services (FTS)
7. Tax Treatment for Royalty and FTS as per Income Tax Act, 1961
8. Tax Treatment for Royalty and FTS as per DTAA
9. Summary

Every person is liable to pay income tax in respect of his total income, as per Income Tax Act, 1961. “Person” includes an individual, a Hindu undivided family, a company, a firm, an association of persons or a body of individuals (whether incorporated or not), a local authority and every artificial juridical person not falling within the above categories.

For determination of taxability, the Act in general, follows a combination of the “source” and “residence” rules. 

Whereby  “source”  of  the  income  determines  its  taxability  in  the  hands  of  the assessee (regardless of other factors such as the assessee’s residential status). And “residential status” of the assessee determines the taxability of income.

Accordingly, as a starting point, it is essential to examine the residential status of the assessee. The scheme for determination of the same is provided in section 6 of the Act.

There are different tests laid down for determining the residential status of individuals, companies, etc. The same would largely depend on factors such as duration of stay in India (for individuals), country of incorporation coupled with existence of “control and management” of the affairs in India or place of effective management (for companies), etc. 

Taxability as per provisions of the Income Tax Act, 1961

Meaning and scope of Total Income 

As per provisions of section 5 of the Act, “income” would be liable to tax in India if it is –

- Received or deemed to be received in India; or
- Accrues or arises in India; or
- Is deemed to accrue or arise in India; or
- Accrues or arises outside India - (the same would be taxable only in the hands of a “resident” assessee). In the case of an individual who is “resident but not ordinarily resident” in India, such income would not be liable to tax in India unless it is derived from a business controlled in or profession set up in India.

Taxability as per provisions of the DTAA

The Central Government of India has entered into agreements with the governments of various countries in order to grant relief of tax or avoid double taxation in case of tax payers to whom such agreement applies. Such agreements are termed as DTAA, being contracts of taxing rights between contracting states. It must be noted that devoid of enabling provisions under the domestic laws of the contracting states, the residents of the contracting states do not get the right to access the beneficial provisions of the treaty, as they are not parties to the said sovereign contracts. As per section 90(2) of the Act , a person resident of a particular country with whom India has entered into a DTAA can claim the beneficial provisions of such DTAA in relation to transactions which are taxable under the Income-tax Act, 1961. Accordingly, as per section 90(2) of the Act, the provisions of DTAA would override the provisions of the Act and in the event of conflict between the provisions of DTAA and the Act, the more beneficial one would prevail. The interplay between the provisions of the DTAA and the Act as explained by the Indian judiciary has been explained in greater detail in Annexure F. Contextually, it may be noted that Indian domestic law currently allowing the tax treaty law to over-ride the domestic tax law is unique unlike most sovereign states, viz. the United States of America, which expressly provide that their domestic tax law or the tax treaty law whichever is later in time shall prevail.

India has entered into comprehensive DTAAs with more than 80 countries for the avoidance of double taxation.

Accordingly, while examining taxability under the provisions of the Act, it is also necessary to examine taxability under the provisions of the applicable DTAA. This facilitates optimization of the overall tax position in India.

Income deemed to accrue or arise in India 

As per provisions of Section 9 of the Act, which is an unambiguous extension of source rule, deals with the 'incomes which are deemed to accrue or arise in India'. Clearly, therefore, an income, in order to be taxed in India under section 9, need not accrue or arise in India. Case law - Qualcomm Incorporated v. ADIT [2015] 56 taxmann.com 179 (Delhi ITAT)

As per generally accepted principles, the deeming provisions governing the scope of total income (i.e., “deemed to accrue or arise” in India) should be examined only if the income is not actually “accruing” or “arising” in India.

This is based on the premise that a fiction is not needed to create a situation which exists in reality. Case law - CIT vs. Oriental Co. Ltd [1981] (137 ITR 777) (Calcutta HC)

Royalty and FTS are two specific streams of income which are liable to tax in India under the deeming fiction, regardless of whether the performance of the income generating activity has been carried out in India or not.